Why the world needs a second (and third) reserve currency

The importance of the dollar in the world economy is based on history. When the Bretton Woods exchange rate mechanism was devised in 1944, the US economy was the dominant force in the world and the dollar the pre-eminent currency.

The economic system set up by the Allies naturally used the dollar to back the fixed-rate regime. But 20-odd years later, the US chose to pay for the cost of the Vietnam war on credit. When the imbalances created by Bretton Woods made continued backing with dollars impossible, as the US economy wasn’t generating sufficient foreign exchange, the system broke down. We moved, ultimately, to the floating rate arrangement we have today.

The problem was, the rest of the economy hasn’t moved with it. World trade is still priced in dollars, everything from crude oil to gold to wheat. While on the surface this doesn’t appear to be an issue, it is a problem when the US constitutes a steadily decreasing share of world economic output and world trade. It cannot be described as economically efficient that when a Malaysian rubber exporter sells its product to a Korean car manufacturer, both parties have to price the transaction in US dollars. As the value of the dollar depreciates steadily (for example, it has lost over 15% of its value against the euro in the last five years), it makes less and less sense to maintain pricing exclusively in this currency.

The export performance of the countries behind the OPEC and Asia-Pacific currencies was a causal factor of the 2007-2008 financial crisis. These countries’ reserves were primarily invested in the west, contributing to excess cheap liquidity which found its outlet in sub-prime mortgage and corporate lending and helped fuel a housing market boom and bust.

The dollar’s status as the world’s prime reserve currency gives the US economy a built-in advantage because it will always find buyers of its assets, in essence the rest of the world. The size of the US public sector deficit is testament to this lack of fiscal discipline. Investors will always seek risk-free assets, which is why the Federal Reserve can always print Treasury bills.

The current situation is not desirable from a number of viewpoints, whether one is a non-US exporter or a bank regulator trying to mitigate the impact of the next financial crash. The obvious solution is an alternative reserve currency, or set of currencies. Of course this is a long-term project; one cannot set up a reserve currency quickly.

We can dismiss out of hand an IMF-style special drawing right (SDR), since this would lack liquidity. The euro is a genuine contender, but has to solve its structural problems first. It needs a centralised fiscal management system (some form of political union) as well as an objective review of whether economically weaker euro countries are viable long-term members.

That leaves the Chinese renminbi. Although not a freely tradeable liquid currency, it is only a matter of time before it does become one. The Chinese economy will be growing over the next 20 years, and as its exports start to dominate world trade, it makes sense to transact more in its currency. The emergence of the offshore renminbi bond market is an early sign of liberalisation and FX liquidity.

If in 10 years’ time the world had three reserve currencies, for both risk-free asset holdings and global commerce, this would be a positive result. Such an outcome would make less likely the kind of global cash flow imbalances we experienced during 2000-2007, which contributed to the crash. This would contribute to economic stability. Exporters would be less exposed to foreign exchange fluctuations, enabling companies around the world to save money on hedging costs. And an alternative to the dollar would enforce an element of fiscal discipline on future US governments, which would be good for the US economy, and by extension, the world.

This is not to underestimate the dollar’s importance. It will still be the main currency for payments and risk-free assets in 10, and indeed 20 years. But the availability of the euro and renminbi on a similar basis, as freely tradable liquid currencies, and with China developing an open government bond market similar to that in the west, will enable central banks to diversify their currency holdings. The world would be freed from the problem of dangerously-correlated risk to the vicissitudes of the US economy and the dollar. This can only be a good thing.

Moorad Choudhry is Acting Head of Strategy and Regulation, RBS Group Treasury, Royal Bank of Scotland; Visiting Professor at the Department of Mathematical Sciences, Brunel University; and member of the OMFIF Advisory Board.

The views expressed in this article are an expression of the author’s personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this article and accepts no responsibility for any consequence of their use. This article does not constitute an offer or a solicitation of an offer with respect to any particular investment.